Commodity traders call natural gas the widow-maker because of its breakneck volatility and extreme price swings.
Nevertheless, our outlook has called for the thermal fuel to remain volatile but range-bound, as spikes toward $3 per million British thermal units (mmBtu) will sow the seeds of their destruction by incentivizing production growth and prompt electric utilities to switch from gas to coal. Conversely, moves below $2 per mmBtu will encourage demand and prompt exploration and production companies to slow their drilling and completion activity.
Against this backdrop, our strategy for gas-levered exploration and production companies has involved buying the dips and selling the rips in the underlying commodity.
Weather-driven gyrations aside, natural-gas prices are close to an important top this summer that could set the stage for the thermal fuel to drop to between $2 and $2.50 per mmBtu later this year.
Let’s start with the supply side of the equation. Natural gas plunged below $2 per mmBtu in the first half of 2016 because of US production growth and reduced demand during the unusually warm winter of 2015-16. However, upstream activity and natural-gas supplies responded to this weakness. The US gas-directed rig count, for example, tumbled to a low of 81 units last summer, from a high of 192 in December 2015.
Monthly data on US gas production is volatile and subject to large seasonal swings; however, a look at the 12-month moving average shows that US gas production began to inflect lower by last May.
In February 2017, US gas production fell 7.3 percent year over year. This helped firm up prices in 2016, propelling front-month gas futures to highs of about $4 per mmBtu in December.
Once again, the tide appears to have turned in favor of the bears.
With natural-gas prices averaging more than $3 per mmBtu since late 2016, the US gas-directed rig count has more than doubled since the end of August 2016, surging to 189 drilling units as of early July.
Stepped-up drilling activity won’t translate into production increases for a few months, but data from the Energy Information Administration indicate that the year-over-year drop in monthly gas output narrowed to 2 percent in April—the lowest level in more than 12 months.
Associated gas production from oil wells could also present a headwind, as these volumes tend to respond to oil prices. In addition to the Eagle Ford Shale, the red-hot Delaware Basin in West Texas and central Oklahoma’s SCOOP and STACK plays produce significant volumes of associated natural gas.
Break-even costs for natural gas have also come down significantly in some US shale plays. At the MLP Association’s investor conference earlier this summer, several midstream operators highlighted how longer laterals and enhanced completion techniques had revivified the Haynesville Shale, a prolific gas play in Louisiana that had fallen out of favor.
The number of active rigs in the Haynesville Shale has more than tripled since September 2016, reaching 43 drilling units; this resurgence suggests that the Marcellus Shale may no longer be the only shale gas play that can grow its output at low prices.
And while gas supply is rising, the demand outlook also appears to be deteriorating.
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Elliott and Roger on Feb. 27, 2018
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